As seen in “Our Colorado News.” Written by John Kokish.
So why are you running your business as a sole proprietorship? Why don’t you incorporate? How about an LLC, but what is that anyway? Maybe you need a partner.
When operating a small to medium size business, making an intelligent choice of what form of entity you want can make a huge difference in the ease or difficulty of how you run the business. Each of the four basic forms of business has advantages and disadvantages, but trying to determine which is best for your business can be a daunting challenge. The four basic forms of business are the sole proprietorship, partnership, corporation and limited liability company. (LLC)
If your business is small and uncomplicated, a sole proprietorship might, in fact, work for you. The bookkeeping is simple, tax filing is uncomplicated and the operation of the business is probably straight forward. But there is one basic problem with a sole proprietorship, and that is that your personal assets are always at risk. If your company goes heavily into debt, a creditor can come not only after your business assets but your personal assets as well.
Some folks worry about injuries happening at the business and potential lawsuits that result from them. That is not a real concern however, since insurance can cover those. But insurance doesn’t cover contractual debts.
A partnership has all of the disadvantages of a sole proprietorship and very few of the advantages. Many people have trouble getting along with their spouses and this can be even more pronounced when trying to get along with partners. Not only do disputes arise, but the liability incurred by your partner can be attributed to you. In other words, if your partner decides to purchase 10 expensive race horses without your permission, you might well be stuck with the bill if your partner then bails out on his obligation to pay for the horses. Partners can be useful for raising money, but the same warning holds true for partnerships as it does for sole proprietorships. Personal assets are always at risk, not only for what you have gotten into, but also what your partner has done. If you enter into a partnership, it is important that an attorney draw up a carefully worded partnership agreement so that all of the partners’ obligations are clearly spelled out.
A corporation is form of entity that was created primarily to protect the owners’ personal assets when properly operated. There are two types of corporations- a C corporation and a Sub-Chapter S corporation, both named after the provisions of the Internal Revenue Service Code that creates them for tax purposes. The C corporation, or traditional corporation, is the form of entity used by all public companies on the various stock exchanges. They have the advantage of allowing unlimited participants, numerous fringe benefits, such as cafeteria plans, group life insurance, disability insurance and other benefits. Most important, the participant’s liability is limited to the amount he/she actually invested in the company, meaning his/her personal assets are safe provided the company is properly run. The biggest problem with the C corporation is double taxation; that is, if the corporation shows a profit, it will be taxed at the corporate level and then taxed to each individual participant when it is distributed. This double taxation aspect makes it less than desirable for many small businesses.
In order to avoid double taxation, the Sub-Chapter S corporation was created. The Sub-S corporation has many of the advantages of the C corporation, but also allows a “flow through” system of taxing profits only to the individual who actually receives the money, and carrying any losses through as well. This can be tricky, however. If the corporation earns money and the shareholder or shareholders do not pay themselves at the end of the fiscal year, are then taxed to the shareholders any way and a phenomenon known as “phantom income” results. This is when you are taxed on profits not actually received. Also, the S corporation has many limitations as to its use, which can hand-cuff the owners in their attempt to make it more flexible.
In recent times, the popularity of the limited liability company or LLC has exploded and is permitted in most states, including Colorado. The limited liability company is essentially a hybrid or combination of the partnership and the Sub-Chapter S corporation. It shields the owners from personal liability, but allows the flexibility of a partnership to remain. It is probably the entity of choice for most small businesses in Colorado because of the “flow through” profits that avoid double taxation, the protective shields for the owners and the ability to allow certain freedoms that the Sub-S corporation restricts. Shareholders in an LLC are known as “members” and the directors are known as “managers,” but the operation of any LLC is similar to that of a Sub-S corporation. Bookkeeping is much simpler than it is in any corporate form and single member LLCs are allowed. Additionally, the owners have a choice of being taxed as a partnership or as a Sub-S corporation. One caveat, however – the phantom income exercise also applies to LLCs.
Ultimately, making the choice as to what entity your business should adopt can be a complicated matter, and the assistance of an attorney or an accountant is truly helpful to avoid putting a square peg in a round hole. As indicated before, all of these forms of entities have advantages and disadvantages and sorting them out may take professional advice.